Deferred Compensation Plans vs. 401(k)s

Deferred compensation plans offer an additional choice for employees in retirement planning and are often used to supplement participation in a 401(k) plan. Deferred compensation is simply a plan where an employee defers accepting a part of his compensation until a specified future date. For example, at age 55 and earning $250,000 a year, an individual might choose to defer $50,000 of their annual compensation per year for the next 10 years until they retire at age 65. The deferred compensation funds are then set aside and can earn a return on investment until the time they are designated to be distributed, or paid out, to the employee. At the time of the deferral, the employee pays Social Security and Medicare taxes on the deferred income just as on the rest of their income, but they do not have to pay income tax on the deferred compensation until they actually receive the funds.

Deferred compensation plans are most commonly used by high-paid executives who do not need the total of their annual compensation to live on and are looking to reduce their tax burden. Deferred compensation plans reduce an individual's taxable income during the deferral, and may also reduce exposure to the alternative minimum tax (AMT) and increase the availability of tax deductions. Ideally, at the time when the individual receives the deferred compensation, such as in retirement, their total compensation will put them in a lower tax bracket, thereby providing tax savings.

Deferred compensation plans are similar to 401(k) plans, but differ in a number of important ways. Here's how:

One reason deferred compensation plans are often used to supplement a 401(k) or IRA retirement plan is because the amount of money that can be deferred into the plans is much greater than that allowed for 401(k) contributions, up to as much as 50% of compensation. The maximum allowable annual contribution to a 401(k) account, as of 2019, is $19,000 (up from $18,500 in 2018), or $25,000 (up from $24,500 in 2018) for individuals age 50 or over, due to catch-up contributions. Another advantage of deferred compensation plans is some offer better investment options than most 401(k) plans.

Where deferred compensation plans are at a disadvantage is in terms of liquidity. Typically, deferred compensation funds cannot be accessed, for any reason, prior to the specified distribution date. The distribution date, which may be at retirement or after a specified number of years, must be designated at the time the plan is set up and cannot be changed. Nor can deferred compensation funds be borrowed against. The majority of 401(k) accounts may be borrowed against, and under certain conditions of financial hardship such as large, unexpected medical expenses, funds may even be withdrawn early. Also, unlike with a 401(k) plan, when funds are received from a deferred compensation plan, they cannot be rolled over into an IRA account.

The possibility of forfeiture is one of the main risks of a deferred compensation plan, making it significantly less secure than a 401(k) plan. Deferred compensation plans are funded informally. There is essentially just a promise from the employer to pay the deferred funds, plus any investment earnings, to the employee at the time specified. In contrast, with a 401(k), an actual formally established account exists. The informal nature of deferred compensation plans puts the employee in the position of being one of the employer's creditors. A 401(k) plan is separately insured. By contrast, in the event of the employer going bankrupt, there is no assurance that the employee will ever receive their deferred compensation funds. The employee in that situation is simply another creditor of the company, one who is standing in line behind other creditors such as bondholders and preferred stockholders.

It is generally advantageous for the employee deferring compensation to avoid having all of their deferred income distributed to them at the same time. The reason: This typically results in the employee receiving enough money to put them in the highest possible tax bracket for that year. Ideally, if the option is available through the employer's plan, the employee does better to designate each year's deferred income to be distributed in a different year. For example, rather than receiving 10 years' worth of deferred compensation all at once, the individual is usually better off by receiving year-by-year distributions over the following 10-year period.

Financial advisors usually advise using a deferred compensation plan only after having made the maximum possible contribution to a 401(k) plan – and only if the company an individual works for is considered very financially solid.